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Friday, August 26, 2011

The Economist Magazine Takes a Closer Look at NGDP Targeting

Here is the article. It does a fair job discussing the pros and cons of such a rule. Among the advantages for NGDP level targeting is that it better handles supply shocks:

They could also react more appropriately to supply shocks. Take the example of an economy that is hit by a negative supply shock through high oil prices depressing output and raising inflation. An inflation-targeting central bank may feel compelled to tighten policy, worsening the slump in output, whereas one mandated to hit NGDP could be more flexible. There could be advantages, too, in the opposite case where a positive supply shock through productivity-enhancing new technology boosts real GDP growth while lowering inflation. An inflation-targeting central bank would respond by easing monetary policy, which could produce asset bubbles, whereas an NGDP-targeting central bank would hold steady. Certainly inflation would be more volatile, but the overall economy would not be.

One of the disadvantages is how to adopt and implement a new rule when it is not widely known:

For all its theoretical merits, a switch to NGDP targeting would throw up some new problems—and old ones. The Fed has not exactly sat on its hands since the financial crisis began in 2007, so it is far from clear it could easily reach the new goal.

The short answer is that the Fed would announce (1) its targeted growth path for NGDP and (2) commit to buying up as many securities as needed to reach it. Knowing that the Fed would be willing to buy up trillion of dollars of assets if necessary to hit its target would cause the market itself to do much of the heavy lifting. That is, the public would adjust their portfolios in anticipation of the Fed buying up more assets and in the process cause nominal spending to adjust largely on its own. I go into more detail here how this would work, but the key point is the Fed would be better managing nominal spending expectations. Such a rule would have better contained nominal spending expectations in 2008 and avoided the worst of the crisis. Just look at Sweden who effectivelydoes something like a nominal GDP level target.

Update: Bill Woolsey provides much more commentary on The Economist article.

7 comments:

I'm fuzzy on how this is supposed to work. Is purchasing securities (what securities?) supposed to increase the price? Why even bother with purchases when you can set the price directly (the Fed only needs to announce a target and the market will go there)?

If the Fed targets a stock market level, sure it would probably be stimulative, but it would be back door fiscal policy - basically giving money to people who own stocks. See the problem? It is horribly inequitable, and has no advantage over conventional fiscal policy.

I don’t have any big objections to NGDP targeting. It is true that given higher oil prices an “inflation-targeting central bank may feel compelled to tighten policy, worsening the slump”. On the other hand an intelligent central bank would not do this. In fact the Bank of England is currently acting in this “intelligent” way. That is, it is deliberately not doing very much about the current 4% or so inflation in the UK because it thinks this excess inflation is explained by temporary factors, including recent raw material price increases.

I’m also not keen on the targeting being done just with monetary or “Fed” measures. These are proving spectacularly ineffective right now, seems to me. QE is not a powerful weapon because it just swaps one asset for another. As to interest rate adjustments, I’m not too impressed by these either for reasons I set out here:

Of course there are currently big political problems in getting Congress to agree to some sort of half intelligent fiscal policy. But my ideal would be to do the targeting with a combination of monetary and fiscal policies.

My personal reaction to committing to this policy would certainly be to protect at least a portion of my assets from the planned inflation - if enough acted similarly, could this occur? Or is this way off base for a reason I don't see. Thanks & great blog!

I am not sure what you mean by "increase the price" since that is not the point of NGDP targeting. Instead, the objective is to target nominal spending at some trend growth path. It works by satiating investor's demand for money assets that, in turn, causes them to rebalance their portfolios toward other assets. This rebalancing will ultimately lead to an increase in investment and consumption spending.

The Fed does this by buying up (or making a commitment to buy so that it creates the expectation it will do so) as many treasuries as it needs, including longer-term ones. And if necessary it could resort to forex and private securities. However, that probably will not be necessary given that expectations are properly set about the future path of monetary policy. (i.e. the public believes the Fed will continue to buy until its NGDP target is hit). So no, your point about doing fiscal policy more conventionally is moot here.

However, in the current circumstances, it would very helpful for the Fed to lower the interest on excess reserves. This would help lower the demand for base money and provide a nice catalyst to reaching a new NGDP target.

Note that Sweden effectively did something like this without resorting to buying up private securities.

If NGDP targeting worked as planned, then in addition to some inflation there would also be an big surge in current dollar spending. Given all the excess capacity in the economy this uptick in nominal spending would translate into real economic growth. And with real economic growth, real returns and real interest rates would increase. Savers would ultimately benefit.

Another way of seeing this is to ask where would interest rates be in the absence of the Fed? Given the sluggish economy it is likely they would still be low. Do nothing and we continue to get Japan-type interest rates for some time. Increase nominal spending with a NGDP target and then interest rates will increase too.

One last thing. What is being proposed here is NGDP level targeting. With a level target there is a period of catch-up nominal spending growth to the targeted trend growth path. But once that trend path is hit, nominal spending growth would return to a slower, normal pace.

From the Governor of the Riksbank: "To instead base long-term forecasts on market expectations of the policy rate is a method we have already tried and decided to abandon. If we use market expectations of the policy rate as a starting point, it may be difficult to determine how the interest rate is connected to other developments in the macro economy. Our own forecast for the interest rate has the advantage that it is produced together with the forecasts for GDP, inflation, employment and so on. Moreover, market expectations can vary substantially over time, which can lead to the information content in the macro forecasts as a whole declining." Thoughts?